How electronic payments can bridge the tax gap
A recent online seminar, hosted by Global Government Forum with the support of Mastercard, explored how civil servants can squeeze the shadow economy by encouraging electronic payments. And the benefits for public finances, research suggests, could be enormous
Cash is king in the shadow economy, where transactions go unreported and taxes uncollected. But electronic payments have the potential to squeeze out cash, increasing transparency and providing a much-needed boost to public finances, according to research revealed at this year’s Global Government Tax Summit – a Global Government Forum online seminar hosted with Mastercard.
The webinar was an opportunity to gain a better understanding of the untaxed shadow economy, its composition and its impact on public finances. At the event on 27 April, EY partner Marek Rozkrut presented the findings of an EY study carried out for Mastercard in Central Eastern Europe over the past two years.
The research offers “a deep dive analysis of the shadow economy area, with some practical solutions to show how electronic payments could support the transparent economy,” said Michal Skowronek, Mastercard’s Senior Vice President for Market Development in Central and Eastern Europe.
Pressure on public finances
Take a glance at the state of public finances around the world, and it’s clear why governments are increasingly keen to squeeze the shadow economy. Mastercard figures show that about 85% of the world’s countries are running public finance deficits, with most of them exceeding 3% of GDP.
The shadow economy puts a significant dent in countries’ tax revenues, contributing to deficits. In Central Eastern Europe (CEE), the problem is vast. In 2014 the scale of the shadow economy as a proportion of GDP ranged from 11.3% in the Czech Republic to 25.5% in Bosnia and Herzegovina, according to a study of eight CEE countries by EY/Mastercard.
One way to estimate the contribution that the shadow economy makes to government deficits is the VAT gap: the difference between VAT revenues received by government, and the sums they’d collect if the tax was always charged and paid. The VAT gap for the EU is estimated at 14% of total VAT liability, according to the EY/Mastercard study. And in some countries, the figure is much higher; in Slovakia, for example, 30% of total VAT liabilities are not collected.
Understanding the shadow economy
Before governments can hope to tackle the problem, they have to understand what they are dealing with and how best to target their resources. The shadow economy is defined, for the purposes of the EY/Mastercard study, as “unreported transactions that are not registered, are not visible, and there are no receipts or invoices to indicate that the transaction actually took place”.
For example, tax fraud – though an important contributor to the VAT gap – is not considered to be part of the shadow economy, because tax fraud tends to draw on reported transactions.
The EY/Mastercard study also makes an important distinction between the “passive” and the “committed” shadow economy. The “passive” component is made up of unrecorded cash payments where customers often hand over their money without being aware that the transaction is unreported and tax is unpaid.
This means the payer should be indifferent between using cash or an electronic payment because the price would generally be the same, said Rozkrut. These consumers are therefore susceptible to incentives aimed at changing their behaviour.
The sector that makes the biggest contribution to the “passive” shadow economy is food, beverages and tobacco – due both to the size of the sector, and to the high proportion of cash payments within it.
The picture for the “committed” shadow economy is different: both sides of the transaction agree to use cash so that the payment can go unreported. This is most prevalent in the construction sector. The buyer benefits from a lower price, and the seller benefits from not paying tax. This means that government measures to promote electronic payments are unlikely to be very effective, said Rozkrut, given that both partners to the transaction are deliberately using cash in order to hide the transaction.
The good news for governments is that the passive component accounts for the large majority of the total shadow economy. In the eight CEE countries considered within the study, the proportion varies between 60.8% in Bulgaria and almost 91% in the Czech Republic. “This indicates that the potential for reducing the shadow economy through the promotion of electronic payments seems to be enormous,” said Rozkrut.
Provided the passive shadow economy is addressed efficiently, EY estimates that the potential improvement in government revenues could range from 1.6% of GDP in Slovenia to as much as 4.2% of GDP in Bosnia and Herzegovina.
Measures to promote electronic payments
A range of government measures to clamp down on the shadow economy are already in use around the world, and some are showing positive results. These include incentives for customers to pay electronically; requirements for traders to install card payment systems; and restrictions on the size of permitted consumer and business cash payments.
South Korea, for example, was an early adopter of an income tax deduction mechanism for households that made electronic payments. More recently, Bulgaria has introduced a new regulation that means taxpayers who make electronic payments can receive up to 1% of relief from due income tax. There are some restrictions, however, and a cap on the tax relief sum of 500 Bulgarian lev (€255/US$283).
Although these tax incentives are often temporary, the effects on behaviour can be permanent. This means that the incentive may be reduced or even fully eliminated after a year or two, without prompting a return to cash payments. “If people have changed their habits and they have understood the benefits of electronic payments, it is very unlikely that they would shift back to cash usage if there is no more incentive,” says EY’s Rozkrut.
Another consumer-focused initiative to discourage the use of cash is to lower the price of goods and services if people pay electronically. Even when the cost of running this kind of cash-back mechanism is taken into account, the net impact is positive, according to Rozkrut.
In some countries, the lack of payments infrastructure is a significant obstacle to change. One solution is to oblige merchants to operate point-of-sale (POS) terminals. A new law in Romania requires every merchant with an annual turnover of more than US$10,000 to have POS terminals to accept electronic payments.
Although there is no guarantee that the POS terminals will be used, the rationale is that increasing the number of places where buyers may use POS systems should increase the popularity of electronic payments. “If this is the case, it again means crowding out some part of cash payments – which in turn leads to contraction of a shadow economy,” said Rozkrut.
Governments do need to evaluate the costs and benefits of different measures, but every cash payment that can be squeezed out of the shadow economy and into the light represents a potential boost to tax revenues and public finances – reducing the space available for transactions in the shadow economy.
Even if a government was to finance 100% of the cost of installing POS terminals, the EY/Mastercard research suggests, the impact in net terms would still be positive: the tax revenues boost would outweigh the money invested. And in the long term, the benefits of encouraging electronic payments year after year could be enormous.
Watch a recording of the webinar here:
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